15th May 2023

Trusts as a tool to protect vulnerable family members

Vanina Wittenburg

Senior Associate

Although the focus in the press is often on the potential tax-saving aspects of trusts, an equally important element of transferring assets to a trust is that of asset and beneficiary protection.

Trusts can be a handy tool for ensuring that assets are preserved and that they are looked after on behalf of family members who may not be able to do so themselves for various reasons. Where assets are held in trust, the trustees have control over them, and can therefore make certain that the assets – be it cash, investments, property, or anything else – are sensibly managed/invested, and for both types of trust discussed below, they will have the power to release the income or capital when necessary.

Creating a trust can be an effective tool to safeguard a vulnerable or irresponsible beneficiary by allowing them to benefit from an asset but giving control of the asset to a third party.

Disabled person’s trust

This is a specific type of trust which can be used to protect a vulnerable person who qualifies as a 'disabled person' and who might otherwise be vulnerable to financial abuse or exploitation from others or be unable to manage their own finances.

A disabled person is defined in the relevant legislation as someone who cannot manage their own affairs because of a mental disorder, or who is in receipt of certain benefits (such as attendance allowance, certain disability living allowance payments or personal independence payments, amongst others).

This type of trust can be created so that the disabled person is entitled to income as of right but not capital (a life interest), or as a fully discretionary trust which allows the trustees to make decisions as to how income and capital are to be distributed, if at all.

A disabled person's trust is a special type of trust for tax purposes, as it does not carry the same tax burden as standard trusts. Although the assets are controlled by the trustees for the beneficiary’s benefit, for inheritance tax, capital gains tax and income tax purposes, the trust assets are treated as belonging to the beneficiary. This usually means a lower tax burden, but in order to achieve this, the trust has to be carefully set up, and specified elections must be made on behalf of the disabled person. There is scope to distribute small amounts from the trust to other beneficiaries, but this is very limited, so the trust should in the main be created just to benefit the disabled person.

Protective trust

The other situation in which trusts might be appropriate is where the intended beneficiary (or perhaps their spouse or civil partner) is or could be, financially irresponsible, for example, because of addiction or poor financial management skills.

In such a case, there may be good reason to create a protective trust. Under such a trust, the beneficiary will be entitled to the income (but not the capital) of the trust as of right, unless certain events detailed in the trust take place, e.g., the bankruptcy or divorce of the beneficiary. Once such an event takes place, the beneficiary ceases to be entitled to the income, and the trust becomes fully discretionary.

A protective trust does not carry the same tax advantages as a disabled person's trust, meaning that income is subject to tax at the higher rates applicable to trusts (though credit for tax paid by the trustees can be claimed by beneficiaries receiving income distributions), and inheritance tax charges may arise whenever capital assets are distributed, and on every 10th anniversary of the creation of the trust. If the trust is created by someone (the 'settlor') during their lifetime, there may also be inheritance tax charges on creation, depending on the value of the assets being transferred and the inheritance tax position of the settlor.

Discretionary trust

Another option is to just create a discretionary trust from the very beginning – this carries the same tax burdens as a protective trust, as set out above.

A discretionary trust is often appropriate in situations where the settlor is just not sure whether the intended beneficiaries are sufficiently able or trustworthy enough to receive income as of right, or wants the trustees to consider specific beneficiaries' circumstances and needs before making any payments.

A discretionary trust provides a great deal of flexibility, allowing the trustees to pay out income or capital at their discretion, usually on the basis of wishes expressed by the settlor as to how they would like the trust fund to be dealt with.

Any of the trusts discussed can be created during the settlor's lifetime, as mentioned above, or on death by the settlor's Will, and in fact, we often include discretionary trusts in our clients' Wills to allow for maximum flexibility. Such a trust can include just some of the settlor's assets, or indeed their whole estate after payment of inheritance tax and administration expenses.

Including a discretionary trust in a Will is particularly helpful because it provides the trustees with a variety of options – for example, the trust can be wound up within two years of death and all assets distributed, if that is deemed appropriate; or it can be retained beyond the two years and in the longer term if it is felt that additional protection is required over the assets.

When creating a trust, it is always worth bearing in mind that there will be administrative costs to running most types of trust, covering any compliance and tax reporting requirements. As discussed above, when creating a protective trust, there may also be tax charges which will need to be accounted for.

Nonetheless, a trust can be invaluable in giving peace of mind to settlors who want to ensure that beneficiaries and assets are protected but require sufficient flexibility to ensure that their family members will have a financial safety net.

If you wish to make provision for a vulnerable family member, we would be happy to talk to you further about the advantages and disadvantages of transferring assets into a trust.